From the course: Foundations of Raising Capital

Why do people invest in businesses?

From the course: Foundations of Raising Capital

Why do people invest in businesses?

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- We've all seen headlines in TechCrunch or Axios talking about some new company raising millions of dollars for their idea. These stories can make it seem like it's easy to raise money, all it takes is a good idea, right? Well, it's actually very difficult to raise money from investors. And according to Crunchbase, only about 5,000 companies raised early stage funding globally in 2018. So if you're going to be one of those rare companies that receives investment, you need to understand why someone chooses to invest in a business. The first thing you need to understand is that investors are running a business too. When they put their own money, also called capital, into a business, they do so because they believe that it's a good deal for them. That's why it's called an investment and not a donation. Most of the time, investors trade you money in return for owning a piece of your company. The market value of your company, or your valuation, is what determines how much ownership of the company you're giving up in return for the capital. Don't worry, you aren't handing them your laptops or a room in your office, but legally on paper, they'll be a part owner of your company. And when someone invests in or purchases part of your company, they're expecting that it'll provide what's called a return, which is short for return on investment. You may have heard the abbreviation ROI before. Returns are generated when the investor receives more money back from your company than what she initially put in. That increase in value comes from your company being worth more than it was when the investment was received. The ownership that you trade in return for cash is what makes it possible for an investor to generate a return. If an investor purchases 20% of your company and your company grows and becomes more valuable, their 20% ownership becomes more valuable too. Imagine that your current valuation is $1 million and an investor owns 20% of your company. That means the investor's ownership is equivalent to $200,000. But if your company does well and it grows to be worth $10 million, their 20% stake is now worth 10 times more, $2 million. The math is a bit more complicated than that, but by eventually selling all or part of that ownership stake, they can recoup their investment and receive a return. So if you're going to receive investment, you'll need to convince an investor that your company is undervalued right now. They need to believe that your company will be worth a lot more soon and by investing their capital into your company, they'll see a big ROI down the road.

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